Blood on the Street

A summer of crisis could be testing ground for managers

STUART FIELDHOUSE

The fall-out from August’s credit crunch is still being felt within the hedge fund industry, and its echoes are likely to be heard all the way to Christmas, if not beyond. Although there was an awareness within the industry that there were problems in the US sub-prime market, there were few portfolio managers who had a good grasp of the coming storm and its implications for a number of core strategies.

Even seasoned CDO managers like Solent Capital were calling the Bear Stearns announcement on 19 July, that two of its CDO funds had effectively collapsed, “an isolated incident”. Datamonitor released a report in mid-July predicting growth in the market for UK sub-prime mortgages as more UK consumers experienced financial difficulties, but British lenders were not given much opportunity to deploy such loan products en masse before interbank liquidity dried up.

It is not fair to say that hedge fund firms were caught completely off-balance by the crisis. There had been concerns voiced about the US economy, the sub-prime sector, and the US housing situation in particular, for many months leading up to August. But it is the scale of the crisis, and the role of major investment banks – in turn the prime brokers to thousands of hedge funds – at the centre of this storm, that has created a host of problems which managers will be grappling with well into the New Year.

Press coverage

The way the hedge fund industry is being portrayed in the mainstream media is becoming an increasing concern for many firms. An industry which has traditionally been largely ignored by both the financial and mainstream press, it is quickly picked on now as the scapegoat for any major financial crisis. The fact that managers are reluctant to discuss their positions openly tends to make journalists yet more suspicious. There seemed to be a readiness on the part of national newspapers to pounce on hedge funds as the real culprit behind the credit crunch in early August. It was not until it become increasingly obvious that the guilty parties were some of the biggest banking organisations in the world, that the witch hunt turned elsewhere.

Going into the crisis, the business pages of the UK nationals were focused on the ongoing private equity debate, and the possibility that the new government of British prime minister Gordon Brown would review the tax breaks provided to the private equity industry. A series of massive LBOs in the UK market in particular, had raised public awareness of the sheer size of the war chests some private equity funds were sitting on in July, and trade unions and back-benchers in the UK parliament were calling for more restrictions on the activities of the private equity industry.

As liquidity dried up, seemingly overnight, the spotlight turned from private equity back to hedge funds. “In the very first days there were immediate cries for a lynching party, and a debate about off-balance-sheet vehicles,” says Andrew Baker, Deputy CEO at the Alternative Investment Management Association. “The focus of attention shifted fairly smartly onto highly leveraged strategies. People were lunging around looking for a target.”

Part of the problem in the early weeks was that hedge funds were once again being lumped together into a homogenous mass, which mainstream media could hold up for criticism. It was also difficult for those who would defend hedge funds in the press from doing so accurately, as no one was really sure where the next big blow-up was coming from, and whether the credit crisis had the potential to escalate into a more deeply systemic failure that would affect multiple strategies.

The public was again left with an impression of shadowy financiers, paying themselves vast sums of money to live their playboy lifestyles while simultaneously wrecking the world’s financial markets via excessive risk taking. Yet the negative media coverage has not put off all potential fund investors, and some deals that were already being negotiated going into August seem to have survived the hysteria. “The stories of huge waves of redemptions do not really seem to have eventuated,” says Baker.

Even deep into September, one fund manager who was not wrong-footed by the crisis, John Paulson of Paulson & Co, who has been singled out for praise by a number of investors and competitors over the last few weeks for making money in the credit space while many other funds were on their way down, was being lambasted by the Daily Mail’s Barry Wigmore for gambling on the “debt misery of thousands of homeowners.”

In summary, it remains difficult for the mainstream business press to report in an informed manner on what is actually happening within hedge fund investment when the earnings of star managers will attract far more public interest, particularly as the ordinary investor has so little chance to invest with them.

Heart of the storm

“Even the most experienced confess to being taken aback by the extent of the chaos few bears could have predicted,” says Liz Chong, an industry analyst with EIM. “We have seen large hedge funds collapse while others have halted investor redemptions or are nursing heavy losses.”

Although some strategies were able to claw their way back into the black in the second half of August, others have sustained heavy losses, with managers reporting declines in August in excess of 20%. These are shocking figures for an investment community that has come to believe that hedge funds are meant to perform differently from the markets, particularly during periods of market volatility.

“The background to all this was buried deep in the Fed’s decision to begin a process of cutting interest rates in the early part of this decade,” says Aspect Capital Chief Commercial Officer, John Wareham.

In March 2000 the Fed funds rate was 6.5%; by the time the tech bubble had burst, it was down at 1%, a 50-year low that sent the world on a yield-enhancing and liquidity-fuelled frenzy. The process is best illustrated by the revenue performance of the major investment banks between 2001 and 2007, especially from names like Goldman Sachs, Lehman Brothers, and UBS.

The heightened level of liquidity has led to a boom in alternative investment products, amongst them hedge funds, CDOs, even online forex trading, which has been surging in Japan at the retail level until recently. It has fuelled the inflation of asset values, which have been seen as a superior means of generating some form of return on savings.

This sense of unending confidence clearly ended at some point in late July, although it remains hard to see which straw broke the camel’s back. The market passed very quickly to a place where assets suddenly seemed much riskier than before, and investors suddenly became concerned about how they could safely reduce that risk.

Essentially, the market became confused and bereft of its fixed points. Highly leveraged Japanese private investors lost thousands of dollars as the yen/NZ dollar carry trade collapsed 9% in two days. On the 2728 July, and the 16 August, the markets saw their highest level of chaos, with a vast amount of position reduction and liquidity withdrawal.

Perhaps one of the key problems facing the alternative investments space has been the degree to which strategies that have generally produced incremental returns have been used, via a process of excessive leverage, to produce enhanced and consistent returns. Investors have been happy with these, but have been caught out when positions that were in theory netted off turned out not to be in practice.

Ratings agencies

The ratings agencies are not out of the woods yet. Their role in the summer’s credit crisis is still being examined, and the way debt, and particularly sophisticated structured products, is rated may still change. According to one hedge fund manager interviewed for this article, who asked not to be named, part of the problem arose from the way in which synthetic tranches were being rated. He was seeing what he called “gigantic credit spreads” emerging between AAA and AA-rated structures.

Others argue that the ratings agencies could not be expected to keep up with the investment banks in terms of the sheer sophistication of some of the credit structures being rolled out the door. Yet these products were still being rated on a regular basis.

As early as the first week of July the Ohio attorney general announced an investigation into the role ratings agencies played in the sub-prime meltdown in the US. Bill Gross, manager of the world’s largest bond fund at PIMCO, argued that the agencies had failed to warn investors sufficiently about risk. At the end of August German Chancellor Angela Merkel added her voice to the growing hubbub, saying it was not acceptable for the entire global community to foot the bill for the agencies’ mistakes.

But it doesn’t end there. In late September the SEC announced it was launching its own investigation into whether the agencies followed proper procedures in the way they rated mortgage-backed debt. US Senators, like Richard Shelby and Christopher Dodd, Chairman of the Senate Banking Committee, have been demanding that more light be shed on the ratings agencies’ role in the sub-prime debacle.

The ratings agencies are coming under increasing pressure to defend the position they enjoyed as providers of independent opinion on structured products, including those linked to hedge fund portfolios, which were selling like hot cakes last year. One fund of funds manager we spoke to for this article did raise the issue of how ratings agencies can be fully independent when they are paid by the manager to rate the structure? Other managers were reticent about just how much credibility the agencies retain in their eyes, but the lack of positive comment speaks for itself.

Strategies

“Not one strategy has remained immune to the sell-off, though credit and quant funds have been the focus of media attention as their losses leaked out,” EIM’s Chong says. “Hedge fund indices, complied by HFR or Credit Suisse/Tremont, are all in the red, month-to-date. These declines reflect current trends: for example, the equity index mirrors the slump in stocks which stunned managers, because the sell-off displayed little regard for strong corporate balance sheets or potential LBO targets. This stemmed from a wide-scale deleveraging by funds and prop desks seeking to cut exposures and/or raise cash in readiness for prime brokers seeking more collateral.”

Quant funds have been singled out for criticism by many investors. According to EIM, they seem to have converged in their use of similar factors in their trading models, models which might have served them very well up until mid-July, but seem to have gone awry since then. “In 2005 convertible arbitrageurs had also been left chasing a limited number of trading ideas – catching them out in May 2005 when they were wrong-footed by downgrades on Ford and General Motors debt which led to unexpected reactions from CDO tranches,” comments Chong.

Quant funds had become the darlings of the investment management industry in the first half of this year. Every major investment house worth its salt seemed to be building an expensive quant desk, and head-hunters were finding it increasingly hard to lure those quants that remained inside investment banks to leave for lucrative hedge fund asset management pastures.

Yet seasoned funds of funds were still sceptical of ‘black box’ funds where managers were reluctant to disclose models to investors. Repeatedly, those who had an investment track record stretching back to the 1980s or earlier have told this publication that quant was off their shopping lists, and were likely to remain there. Events in August seem to have proved them right.

“One school of thought contends that large quant managers nursing losses in their fixed income books sought to raise cash by closing long positions and covering shorts – confusing markets as these trades were carried out at the same time, in a shockingly un-quant way,” says Chong.

Some investors take this a step further, questioning whether many quant programs share common characteristics, partly based on common origins within the quant ‘skunk works’ within the bowels of investment banks. In a testing situation, according to one fund of funds manager who asked not to be named, “they all run home to daddy.”

“Not one strategy has remained immune to the sell-off, though credit and quant funds have been the focus of media attention.”

“The drivings of computerised long-horizon equity strategies – earnings, book value, sales, cash-flow – started off poorly in August, triggering some unwinding of quantitative portfolios, which turned into a rout on 9 August, with market activity which could only be described as panicked,” says Martin Coward, founder and CIO at IKOS.

“With the quants the issue was one of contagion,” adds Christopher Jones, CIO at Key Asset Management, a fund of funds. “We hope quants will learn from this. Certainly, many funds of funds underestimated how correlated all these quant funds could be.”

According to a source at Winton Capital: “Many of the quants were using similar strategies, doing similar things, and the smart ones will have learned that things that don’t seem to correlate do.” He argues his own firm’s success (up over 12% from the middle of August to 2 October) has been due to “a better systematic investment program and the use of lower leverage.”

Long/short equity, despite being one of the real bread-and-butter strategies that investors do understand, has still disappointed. There was a distinct feeling going into this crisis that there were far too many managers running long/short strategies that, while being comfortable managing the long side of their books, were doing lip service to their short books. In effect, while they could benefit from bull market conditions, their figures told a different story by the end of August. The tale of woe is graphically reflected in the manager letters some funds of funds were receiving in September.

HOW THE CRISIS WAS CHARTED BY THE WORLD’S MEDIA

11 July

“Subprime Mortgage Market Set To Grow” (Reuters) A report by independent market intelligence firm Datamonitor predicts an increasing demand for subprime mortgages in the UK as more consumers encounter financial difficulty.

18 July

“Bear Stearns Hedge Funds Wiped Out” (Daily Telegraph) Bear Stearns writes to investors to inform them that two hedge funds specialising in CDOs are now virtually worthless. This is the first signal that a very real crisis is emerging.

20 July

“AAA Rating May Be Junk” (New York Times) Questions emerge about the wisdom of securitisation in the wake of the Bear Stearns debacle, with the relative value (or lack thereof) of credit ratings front and centre.

6 August

“How Bear Stearns Mess Cost Executive His Job” (Wall Street Journal) Warren Spector, President and COO of Bear Stearns is fired by CEO James Cayne as a result of the bank’s hedge fund debacle.

9 August

“BNP Paribas Suspends Funds Because of Sub Prime Problems” (Reuters) The French bank suspends three hedge funds because of problems with effectively pricing their assets.

10 August

“Sold Down The River Rhine” (The Economist)IKB Deutsche Industriebank is bailed out by a consortium of German banks and the country’s banking regulator after it diversified into CDO investments, a move endorsed by Moody’s last year.

11 August

“Hedge Fund Panic Was Behind Global Stock Markets Collapse” (Daily Telegraph)Rumours fly on both sides of the Atlantic as a number of hedge funds are named as being potentially in trouble, including some quant funds. Prime brokers start to restrict their lending criteria to hedge funds, causing further problems.

14 August

“Hedge Funds Prepare For Mass Redemptions” (Financial Times)The FT flags up a red letter day for the hedge fund industry, as investors looking to redeem from funds with 45 day notice periods draw up their notices for end of September delivery

30 August

“Australian hedge fund goes under”(BBC)The $100 million Australia-based Basis Yield Alpha Fund is served with default notices as it fails to meet demands from creditors.

31 August

“Merkel Hits At Ratings Agencies” (Financial Times)The German Chancellor adds the international ratings agencies to her list of culprits responsible for market instability. Her comments follow similar remarks from the European Central Bank and Nicholas Sarkozy.

12 September

“Hedge Funds Not The Cause Of August Turmoil” (Reuters)UK, Japanese, and Hong Kong regulators confirm that hedge funds were not to blame for August’s market misery and are unlikely to face a crackdown.

13 September

“Forsyth Partners Goes Into Administration”(AFX)Dubai-based fund of funds calls in the receivers after the Dubai Financial Services Authority revoked its license due to its failure to meet capital adequacy requirements.

20 September

“Hedge Fund Firm Bars Withdrawals By Investors” (International Herald Tribune) Shares in hedge fund manager Absolute Capital plunge following the departure of star manager Florian Homm. Absolute bars investors from redeeming in excess of $100 million from eight funds as the portfolios are hit by pricing problems in OTC securities.

2 October

“UBS Pays The Price” (The Independent)Switzerland’s largest bank writes down SFr4 billion in losses within its fixed income business and announces 1500 redundancies. It represents the bank’s first quarterly loss since the 1998 LTCM crisis.

“CTAs went through this in the early 1990s,” says Peter Rose, Chief Investment Officer at Integrated Alternative Investments (part of Integrated Asset Management) and formerly Director of Research with Ivy Asset Management in New York. “They woke up to the correlation issues and implemented smarter portfolio allocation and risk management techniques.”

Rose saw similar correlations in February’s mini-crisis, and in October 2005. “You have to try to read through the numbers all the time, and do some solid research,” he says. “In 2005 the markets were sold off, but the volatility was low. You would have had to read the numbers carefully to see what the manager was doing. The monthly figures are no longer enough.”

As for credit, which more than any other strategy was caught at the heart of the storm, the diversity of credit sub-strategies has meant widely differing returns from managers in this space. If anything, vanilla long/short bonds have been one of the better performers. Fixed income has had a benign environment in the last three years or so. Now that volatility is picking up, it could well be time for some long/short managers to shine. Event-driven and distressed debt funds could also post some good numbers. The question will be whether the funds of funds, which have tended to be underweight fixed income, will be able to make the right choices between the various sub-strategies on offer.

“Event driven is going to be a fascinating area,” says Rose. “It’s not so straightforward, although it was popular in 2005. Distressed debt, well that’s about patience, and understanding why you’re allocating to it. The opportunity set has not increased that much, but it will be massive over the short to medium term as the second stage of the private equity deals done in 2006-2007 start to unwind.”

Funds of funds

As they bang out their redemption requests, some funds of funds may be reconsidering the way they have gone about selecting underlying managers for their portfolios. There has been a tremendous amount of growth within the hedge fund industry funnelled through the big fund of funds shops, but the size of these big players has thrown up its own set of new problems in the wake of the credit crunch.

“This crisis has happened as the hedge funds industry has been trying to become an institutional model,” says Integrated’s Rose. “Large funds of funds houses have been hiring large research teams, but they have been young research teams. The smart guys are not meeting the managers anymore – they may be sending along the investment committee, but they are not engaging the hedge fund managers in insightful conversation.”

Many large funds of funds have a relatively small universe to choose from, given they don’t want to own more than 10% of any given fund. “They have restricted themselves to a small group of managers, and the real problem has emerged in equities, because they have favoured equities due to their experience in the 1990s, when they provided the best risk-adjusted returns,” explains Rose. “They have been heavily weighted towards equities, but a lot of the long/short managers have been running too much money.”

Apart from correlation, liquidity has become another hot issue with funds of funds. Watching gate clauses being invoked across their portfolios has been a wake-up call for some CIOs. Rose sees some managers without the right gates in place being used for liquidity by panicky investors. “There are still plenty of [underlying managers] offering good liquidity,” says Key’s Chris Jones. “All hedge funds have clauses or gates to some degree, but liquidity is getting noticeably less. On the fund of funds side, there are still firms offering fortnightly liquidity.”

On the upside, new arrivals to the hedge fund market in the last few years are likely not to have been stung too badly in August. Many will have allocated money between two or three of the big fund of funds providers, but may have misunderstood the diversification benefits they would be earning from this sector. “They thought they were getting an investment that would protect them in the month of August, and they would probably have been disappointed,” argues Rose. “It would not have been the end for them, however. Ultimately, their losses would not have been horrendous; they might have been minus 2-3%. They may focus on the best performing funds of funds after this, perhaps even re-allocate to some smaller funds of funds, specialist strategy firms, and those with a more defined mandate.”

This year could help to push the funds of funds business along an evolutionary path it is already travelling, with more sophisticated firms managing more detailed mandates, tailored closely to client requirements. It may no longer be a question offering beta to equities or beta to bonds.

Those investors not yet exposed to the market will not necessarily be tearing up their plans to invest either. Investment boards will keep them on the table as an option, but will no longer feel they’re missing the boat by not investing now.

Where to now?

It is becoming increasingly difficult to predict where markets will move next, and harder yet to gauge the damage done to the hedge fund industry by the chaos in August. Much depends on the speed at which investors are allowed to redeem assets from managers they perceive to be stricken. Gate clauses and redemption penalties may stem this to an extent, but seems unlikely to turn sentiment around entirely.

“I bet a lot of redemption requests have just gone in,” says Soondra Appavoo, a former funds of funds manager now running PSource, a joint venture specialising in helping hedge funds to list on the London Stock Exchange or AIM. “I’m expecting a lot of funds to go out of business in December and January.”

We could be seeing a delayed effect of the real hangover from this crisis, as portfolio managers hide behind their gates hoping to turn things around before they have to return money to investors. Whether this will make any difference is an open question: a meeting of family offices and private banks in Switzerland last month at which these issues were discussed created the strong impression with this writer that it wouldn’t. One senior Swiss private banker, who spoke on condition of anonymity, said that once the redemption request was lodged, it was highly unlikely that his investment committee would change their minds about a manager, regardless of his performance during the interim.

On the upside, those institutions redeeming from ailing managers are not writing hedge funds off entirely: indeed, they are seeking to re-allocate capital, possibly on more favourable terms. Some previously closed funds have reopened briefly to take on new investment in the last few weeks. In addition, seasoned funds of funds CIOs are using this opportunity to cast around for new investment talent that has proved its credentials by trading well over the summer. “If funds of funds are re-positioning, will they be able to do the operational risk on the niche managers?” questions Integrated’s Rose. “They should not be asking the bog standard questions…ultimately, they will get more diversification if they can manage it.”

He sees the end investors as the real drivers of change in the hedge fund industry in the wake of the crisis. The bifurcation of the industry, which began earlier this decade, is likely to be exacerbated, with a separation of managers into those who specialise in catering to institutional investors, and those focused on the wealth management space. Rose sees large funds of funds using indexes or synthetic hedge funds to replicate the beta hedge funds can deliver, and then selecting from a more specialised universe for alpha.

His concerns are echoed elsewhere in the fund of funds sector, where CIOs are now increasingly looking for strategies that can really prove they are uncorrelated to the markets. It is a quest that looks set to occupy more of their time going forwards.

So how positive are hedge fund managers really feeling about the future? On 26 September New York hedge fund consultant Rothstein Kass said its flash survey had found 61% of the 239 hedge fund principals it had interviewed were predicting economic recession in 2008. Continuing market volatility is also expected by the vast majority (87%) of the managers interviewed. Seventeen per cent of those interviewed were anticipating a negative impact on their funds, while 67% were expecting a recession to provide them with investment opportunities.

“An important part of hedge funds’ appeal is their ability to outperform in turbulent or recessionary market conditions,” says Howard Altman, Co-Managing Principal with Rothstein Kass. “It makes perfect sense that principals would be focused on the opportunities that current market conditions provide. In fact, over 81% of principals said that market volatility favours hedge funds over traditional investment vehicles.

The report also discovered that fewer than 15% of managers expected to have to change the underlying strategy of their funds in the face of adverse economic conditions, although 43% accepted that they would need to change specific investments within their portfolios.

In short, while hedge fund managers are braced for a recession in 2008, they are still confident that their approach to money management will prosper in good times as well as bad.

Conclusion

Sitting in front of a trading screen in August, and hearing some of the bad news coming out of the investment banks, one might have been tempted to call time on a very large slice of the hedge fund sector. Ultimately, however, the raison d’être for hedge funds has not vanished, although serious questions have been asked, and will be asked, about the way some funds structure themselves, and the way they manage investors. For the Stephen Cohens of this world, and visionaries like John Paulson, with the performance numbers in August to demonstrate that they have indeed earned their salt, terms and conditions will not be questioned. For others, however, it may prove to be a rough autumn.

Winton Capital, with decent numbers in August and September, doesn’t see the need to impose any gates. The argument here is that managers who do what it says on the tin, who can make money in roughtimes and smooth, do not need to impose barriers to keep investor money in their funds. “We have not charged any redemption penalties since the inception of the fund and we do not intend to introduce any new ones,” says a Winton insider. “We have had net additions of over $100 million in September.”

Not everyone is feeling as secure as Winton is, however. One institutional investor admitted to this writer he would be sending out a team in September and October to carry out a face-to-face review of every single hedge fund manager in his portfolio, and he is unlikely to be alone. One of the emerging themes in the wake of this crisis within the hedge funds industry is likely to be its impact on the relationship between fund managers and investors. AIMA’s Andrew Baker sees a new climate where increased transparency, and an emphasis on investor reporting will prevail. Integrated’s Peter Rose sees funds of hedge funds engaging more closely with their investors to develop products and strategies tailored to their needs. And PSource’s Soondra Appavoo sees more funds going to the market to list, providing themselves with more permanent capital, and investors with a greater degree of liquidity and communication.

There is no doubt that much of the fall-out from this summer will occur organically, and at a slower pace, as managers over the next few months finally give up the ghost and accept they do not have sufficient capital to continue. But those who do survive, with the confidence of their client base intact, will be in a much stronger position in many respects than they were going into August.